CONTEMPLATING THE DEATH OF ABENOMICS Alex Lee Portfolio Manager, Japanese Equities nfollowing a series of scandals, Japan s prime minister Shinzo Abe saw his approval rating tumble ahead of a critical year for Japanese politics. nabe s departure would end a rare period of political stability and create uncertainty around the market-friendly policies he has championed. nshould Abe depart, which seems unlikely for now, we would expect a short-term rise in the yen and correction in equity markets. nhowever, in the longer term we remain bullish on Japanese equities. In a country where prime ministers tend not to last, Shinzo Abe has been hugely successful. Since his election in 2012, he has presided over unprecedented stability. So-called Abenomics has proved to be a powerful economic agenda that has supported strong economic growth and rising asset prices. Under his watch, Japan s Topix equity index has almost doubled. Yet his star is waning, making markets vulnerable. Abe s popularity has diminished after being caught up in a series of scandals and focusing on controversial social policies. Over the summer, his approval rating was in freefall, approaching low levels from which no prime minister in Japan s recent history has recovered. Many market participants seem to assume that he will bounce back with his leadership uninterrupted, but this is by no means guaranteed. All of this is happening at a crucial point in Japan s political calendar. It s conceivable that, if Abe were to go, he could be followed by Bank of Japan governor, Haruhiko Kuroda. If this were to happen, both architects of Japan s reflationary policies would have gone. Monetary policy tightening could be brought forward, which would lead to higher interest rates, a stronger yen and weaker equity markets, in the short term at least. There s a lot at stake. Abe played a key role in the formation of the current dovish Bank of Japan policy board. In 2012, he successfully campaigned for leadership on a reflationary agenda, and subsequently put pressure on the Bank of Japan to ease monetary policy. He appointed Kuroda as governor in March 2013, after which Kuroda introduced qualitative and quantitative easing, significantly expanding the central bank s balance sheet. If Abe resigns, we expect any successor to be less dovish. 3
That said, while the recent stable political environment and expansionary monetary policy have helped Japan s economy and markets, they haven t been the only factor. Global growth, corporate governance reform and the increasingly tight labour market are more important drivers. Political uncertainty could trigger market volatility in coming months, especially in the currency. However, we believe that the economy is fundamentally strong, while a market correction might prove a good entry point to buy Japanese equities. It s important to note that our base case is that Abe survives this scare, Kuroda stays on as central bank governor and the stable political environment remains until 2021. Certainly, Abe has begun his fightback with a cabinet reshuffle in August, whilst Japan s strong economy should also be supportive. However, the risk of political disruption remains high. This week Prime Minister Abe called a snap election, to be held in October. Why would Abe call a snap election? And what could the implications be? Why has Prime Minister Abe called a snap election? Back in 2014, Abe called a snap election, more than two years before any election needed to be held. At the time Abe s popularity had started to slip, and there was growing criticism that his Abenomics policies were not working. Abe s Liberal Democratic Party (LDP) won the election convincingly, and Abe used the result to reconsolidate his power. Fast forward two years and the environment is similar, albeit more extreme. Abe s popularity rating collapsed over the summer, and there is constant speculation around whether the Prime Minister is the still the person to lead Japan. Abe is no doubt on the lookout to find a way to once again consolidate his power base and clear the road of naysayers. A successful election campaign could do just that, and put him in a strong position to hold on to power in next year s LDP leadership election. Why now? The timing may be right for Abe. Firstly, Abe s approval rating has recovered somewhat in recent weeks, but there is no guarantee that this is sustainable. The Prime Minister may therefore try to capitalise on this recovery now. His popularity first bounced following a cabinet reshuffle, but this rarely leads to a sustainable recovery. The recent rise in geopolitical tension over North Korea has also increased his popularity. But again, it is difficult to know how long this will last. Secondly, there is very little competition. The main opposition party, the DPJ, is in disarray. It has seen several changes in leadership in recent years and is incredibly unpopular. A wild card may come from Tokyo Governor Koike s the newly formed political party. Under the banner of Tokyo First, Koike unexpectedly defeated the LDP by a landslide in July s Tokyo elections as voters rebelled against the incumbent LDP. On the same day that Abe announced 4
that he would call an election, Koike announced that she would take on the LDP on a national scale through the formation of the Party of Hope. It remains to be seen whether the party has enough time to recruit enough credible candidates to do damage to the LDP in the upcoming elections. However, given Koike s performance in the Tokyo elections, her party should not be underestimated. What are the implications? The question is not whether Abe s LDP party wins or loses the election. A LDP victory is all but guaranteed since the only alternative mainstream party, the DPJ, has almost no public backing today. What we need to pay attention to is how well the LDP performs in the election. If Abe wins and the LDP maintains a majority close to its current level, then this will act as a signal to the party that an Abe-led LDP party continues to have the confidence and support of the Japanese people. In this environment, the major LDP factions would throw their renewed support behind the Prime Minister, effectively keeping him safe from any challengers to his leadership from within the party. However, should the LDP perform badly in the election and see a substantial fall in the number of seats held, Abe s future would become even more clouded. The LDP is a highly fragmented party, comprising several factions that would like to have one of their own as prime minister. Abe has done a good job of keeping the leaders of the major factions onside by giving them positions in his cabinet or leadership roles within the LDP. Most of those politicians who could threaten his leadership currently support him. However, a poor showing in the election could lead to claims that he has lost the confidence of the people and so no longer has a mandate to govern. His public approval rating could once again fall. Contemporaries within the party could become emboldened to stand against him for party leadership. The risk of him standing aside, either immediately or in the coming months, would significantly rise. ABE S FALLING RATINGS Abe s cabinet approval rating has recently been in freefall. Since the beginning of 2017, he has been dogged by a series of scandals and unpopular policy decisions. Both the Moritomo Gakuen and Kake Gakuen affairs have involved unproven claims of corruption in public life. These have been accompanied by the ruling coalition s decision to pass a controversial anti-conspiracy bill into law and Abe s push for constitutional reform, an issue that splits Japan. As public perception has switched from associating Abe with economic success to controversy, so his approval ratings fell. At its lowest, certain polls have put his rating below 30%. This is worrying, since an approval rating of below 30% has typically been thought of as the level at which there is no way back triggering the resignation of numerous past prime ministers. In fact, Abe himself resigned from his first term as prime minister in 2007, after exactly one year in power, citing ill health but coinciding with a collapse in his approval rating to around 30%. 5
Figure 1: Combined approval rate 140 120 100 80 60 40 20 Koizumi Koizumi-Kim Jong-Il meet Abe Aso Fukuda Kan Hatoyama 0 2001 2003 2005 2007 2009 2011 2013 2015 2017 Cabinet support Cabinet support + ruling party support 50% line Noda Abe Source: BofA Merrill Lynch Global Research, NHK More recently, Abe has seen a recovery in his approval rating. This follows a successful cabinet reshuffle and rising geopolitical tensions with North Korea. Regarding the latter, the public appreciate the stability that the Abe government provides in these worrying times. The problem Abe has is that there are still concerns over his own credibility. Cabinet reshuffles rarely lead to a sustainable rise in the government s approval rating. Should tensions with North Korea ease, Abe could see his popularity wane. As mentioned earlier, this could hardly be happening at a worse time. Abe s Liberal Democratic Party (LDP) is due a leadership election by September 2018. If Abe s LDP party performs poorly in the upcoming elections, or should Abe s approval rating subsequently fall again, he may come under intense pressure to resign from within his own party. Furthermore, governor Kuroda s term at the central bank is due to end in April 2018. Whoever is prime minister at the time will influence the next appointment. All in all, it s conceivable that Japan s leadership could completely change by the end of 2018 and, with it, the outlook for fiscal and monetary policy. ODDS ON SURVIVAL Can Abe survive? Yes. We would put a 60-70% probability on Abe s recovering and overseeing a third term as prime minister. Assuming he wins the upcoming election, what else does he have to do to survive? To answer that question, we need to think about how Abe got into this situation in the first place. Firstly, he has been involved in several political scandals that have given the impression that he uses his power to help friends. In the Moritomo Gakuen affair, Abe and his wife had ties to an ultra-nationalist kindergarten that bought state-owned land at a reduced rate; in the Kake Gakuen affair, Abe was accused of intervening to help a friend establish a veterinary school in a special economic zone. Secondly, Abe has been viewed as complacent and unapologetic in the face of these scandals. Finally, support for his policies, once a big positive, has recently vanished. Abe needs to combat these problems if he wishes to regain the public s trust. 6
At the start of August, Abe began to fight back with a cabinet reshuffle. His new cabinet appointments showed keen political insight, suggesting that he knows what to do. Although it is difficult for Abe to distance himself from the scandals; he did put senior, steady hand ministers in charge of the ministries of education and defence, two areas caught up in the recent controversies. He also appointed cabinet members who have been openly critical of his policies, probably to prove that he does not always favour his supporters and friends. Turning to his policy focus, Abe emphasised that he will once again focus on the economy. Japan s economy is currently in great shape, with signs that wage inflation may finally be on the horizon after decades in hibernation. There is no better way for Abe to regain popularity than by being seen as the architect of this success. RISK A MORE HAWKISH ERA? While Abe seems likely to survive, there is a clear risk that he will not. In this case, there would be consequences for markets, as his departure would probably be associated with a less loose monetary policy environment. Abe is synonymous with Japan s recent reflationary era of monetary policy. He campaigned in 2012 on a platform of reflation and he appointed the dovish Kuroda as governor of the Bank of Japan, who in turn triggered the central bank s massive balance sheet expansion that drove down long-term interest rates and led to the yen s depreciation. None of Abe s potential successors as leader of the LDP party and, therefore, prime minister appear so dovish. Front-runners include Taro Aso, Fumio Kishida and Shigeru Ishida, all of whom are more likely than Abe to accommodate the Ministry of Finance s demands to balance the budget, fostering a tighter fiscal environment and creating a headwind to economic growth. As for the Bank of Japan, there would be less political pressure to conduct loose monetary policy. Expectations for a revision of the central bank s yield curve control, to allow for higher interest rates, would likely rise. The probability of higher rates and, with them, lower inflation expectations, would likely lead to a stronger yen. With Bank of Japan governor Kuroda s term due to end in April 2018, whoever is prime minister at the turn of the year will have significant influence over who is nominated for the role. Kuroda has the support of most of the LDP, and so the most likely scenario is that he stays on for a second term and monetary policy remains loose. However, if he is replaced, the chances are high that his replacement is less dovish. We would not expect any sharp change in policy direction, but the market might price in a higher likelihood of monetary tightening in coming years. This, again, would mean higher interest rates and a stronger yen. 7
WHAT THIS MEANS FOR EQUITIES To reiterate, the most likely scenario today is that both Abe and Kuroda remain in power. In this case, nothing will change. In the unlikely scenario that both Abe and Kuroda were replaced, asset markets could correct significantly in the short term. Even if Kuroda stays but Abe goes, we would expect equity markets to correct, given Abe s close association with the reflation and revitalisation of Japan s economy. In either case, we would expect: nthe yen to appreciate in expectation of higher interest rates and lower inflation. nequities to fall on concerns over the impact of yen appreciation and weaker growth prospects for the domestic economy. nequities dependent on domestic demand to outperform exporters because of the stronger yen. Indeed, a more hawkish Bank of Japan could have global repercussions, as the central bank has been a source of global liquidity since the start of its qualitative and quantitative easing policy in 2013. However, even if Abe and Kuroda were to depart, we would remain positive on the outlook for Japanese equities for several reasons. Japan is highly geared to global demand, which is strong at present. Further, corporate governance is on a clear path of improvement, leading to higher returns on capital. And, the tight labour market is driving efficiency improvements at Japanese companies, which we expect to result in higher productivity and higher earnings. Finally, Japanese equities are attractively valued. There is no doubt that the end of Abenomics would lead to market weakness in the short term. However, a correction could create an opportunity to add to high-quality Japanese companies. Prime Minister Abe has overseen unprecedented political stability since taking power in 2012. While we believe that Abe is most likely to remain in power, we will be watching his approval rating closely. If he were ousted, this would no doubt spark short-term volatility, with monetary conditions tightening, an appreciation in the yen and falling equity markets. However, this could be an opportunity to buy high quality companies on attractive valuations as strong global growth, improving corporate governance and rising domestic productivity make us bullish on Japanese equities from a medium-to-long-term perspective. 8